Yes, Tax Increases Hurt the Economy
It was 2003 and I was in Vienna, Austria I studying for my LL.M. degree in international tax law. I was listening to a lecture and my professor quoted Jean-Baptiste Colbert, a French economist who served as the finance minister for French King Louis XIV.
Colbert declared that “the art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.”
The “hissing” Colbert referred to is the natural inclination of individuals to adjust their behavior when taxes rise or fall, or when tax policies change. Economists refer to this phenomenon as “distortion.” Not surprisingly, the bigger the change in tax rates or tax policies, the greater the distortion.
This may sound like common sense…and it is. But it’s a phenomenon that needs to be constantly rediscovered by mainstream economists.
Thus, it’s refreshing that no less mainstream an institution than the World Bank has concluded that – gasp – tax increases harm the global economy. And the World Bank study suggests that the harmful effect increases exponentially, not arithmetically. In other words, if a tax increase of X% leads to a loss of economic output of $1 trillion, a tax increase of 2X% will result in an economic loss much larger than $2 trillion.
That’s not to say that I oppose all taxes. To a certain degree, I agree with the statement from Supreme Court Justice Oliver Wendell Holmes that, “taxes are what we pay for civilized society.” Yet when Justice Holmes wrote these words in 1927, most Americans paid income tax at the whopping rate of 3%, and the top tax bracket was 25%.
I also accept the premise that some functions of government must be supported by taxes. Two examples are national defense and border security. Yet today, most of the hard-earned dollars Americans pay in taxes supports politically popular transfer payment programs such as Medicare and Social Security.
These programs guarantee certain benefits to individuals whose tax payments qualify them. In return for paying taxes, they’re entitled to benefits that can far exceed their original contribution. As if someone else is more “entitled” to your money than you are.
The aging of the American population means the long-term future of these programs is bleak. for instance, the Congressional Budget Office estimates that Social Security will become insolvent in 2029. Without modifications to the program (e.g., increasing the retirement age to 70 or higher), benefits paid after that date will be sharply reduced.
But at least you’ll get something in return for your “contributions,” even if it’s a lot less than you were promised. Your involuntary “investment” in Social Security will be more successful than, say, the money Americans have spent since 1970 trying to improve the quality of public education. The per capita cost (in constant dollars) of educating a child in public school from kindergarten through high school has nearly tripled. Yet there’s been zero improvement in student performance since the 1970s.
American taxpayers have also spent trillions of tax dollars to make college more affordable. Yet, the main consequence of this subsidy appears to have been to empower colleges to charge much higher tuition rates than they did a generation ago.
Again, some amount of tax is necessary to pay for the essential functions of government. But when faced with budget shortfalls such as the trillion-dollar deficits being racked up by Congress each year, spending cuts do much less harm to the economy than tax increases.
For instance, the largest spending cuts in US history took place immediately after World War 1 (ending in 1918) and World War 2 (ending in 1945). Mainstream economists predicted the cuts would lead to financial disaster. They didn’t. Instead, the money that had been used to manufacture munitions and pay soldiers was reallocated into more productive uses, and in both cases, the economy quickly recovered.
It’s time for the geese to keep more of their feathers. Congress, are you listening?
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